Who will finance America’s deficit?

A comparison of Obamanonomics and Reaganomics is instructive. Even in the unlikely event that the Obama administration were to adopt Reagan-style incentives to risk-taking and investment, the effect of such incentives would be weaker and slower to take effect than in 1981-1984.

The United States government needs to borrow US$1 trillion a year, before a new stimulus package, or handouts for the auto industry, or healthcare reform, or a dozen other spending programs promised by the incoming administration of president-elect Barack Obama. Where will the Treasury find the money?

A bizarre jump in the US Treasury’s real cost of borrowing points to severe market disruption if the Treasury deficit continues to rise. It appears that the Treasury market is also a victim of global de-leveraging. The new administration has far less budgetary flexibility that it seems to think. In 1981, under comparable

circumstances, Ronald Reagan had far greater room to maneuver. I conclude that the new administration is virtually powerless to prevent marked deterioration of the US economy.

A comparison of Obamanonomics and Reaganomics is instructive. Even in the unlikely event that the Obama administration were to adopt Reagan-style incentives to risk-taking and investment, the effect of such incentives would be weaker and slower to take effect than in 1981-1984.

As shown in Exhibit 1, the yield of the 10-year inflation-indexed Treasury (TIPS) tripled from 1% to 3% between June and October 2008. Nominal Treasury yields fell slightly, because the inflation-expectations component of Treasury yields (the difference between ordinary 10-year Treasury notes and inflation-indexed TIPS) collapsed, from 250 basis points to less than 100 basis points.

The jump in TIPS yields should ring alarm bells. It is not only that inflation-indexed Treasury yields never have risen so fast and so far since their introduction in 1997. What is most bizarre is that the movement in “real” Treasury yields is not only massive, but in the wrong direction. Both economic theory and all past experience tell us that when economic activity falls, “real” yields also should fall.

Exhibit 2 below shows that 10-year TIPS, or “real” Treasury yields have moved in the same direction as equity market returns. The inflation-adjusted Treasury bond yield is a rough proxy for real long-term interest rates (it is only a proxy because the consumer price index – or CPI – is not necessarily a good measure of inflation). Real rates are supposed to reflect growth expectations; higher growth means higher returns to financial assets, including bonds. TIPS yields are plotted against 12-month returns to the S&P 500. The two lines move together except during the past few weeks, when they take sharply opposed directions.

Exhibit 2: TIPS yields triple while S&P 500 crashes.

How weird the behavior of TIPS yields has been during the past few months is made even clearer by Exhibit 3, below. We observe that TIPS yields and S&P 500 returns lined up neatly between 2004 and 2008, and suddenly moved in the opposite direction.

Just when we should have expected “real” Treasury yields to collapse along with equity market returns, they spiked upwards, and by the largest margin on record. Evidently something has changed, and changed drastically. One component of Treasury yields, expected inflation, has collapsed, and the “real” component has jumped.

There is no question as to why the expected-inflation component has fallen, for it has done so along with the S&P 500 and the main commodity price index (the Constant Maturity Commodities Index published by UBS and Bloomberg). This relationship is shown in Exhibit 4 below.

Equity, commodity and Treasury bond markets all are registering a deflationary crash in precisely the same way. That seems clear enough. The dog that barked, but shouldn’t have, is the “real” component of Treasury yields.

The answer to the mystery of tripled real Treasury yields is to be found in the collapse of leverage in the global financial system. Indirectly, the rapid expansion of leverage in the global banking system contributed to demand for Treasuries. When de-leveraging commenced in August, an important component of demand for Treasuries declined sharply. That is bad news for Washington, but even worse news is that it will continue to decline sharply, just when Washington most requires global support for the US government debt market.

Global leverage indirectly increased demand for Treasuries in three principal ways:1. It fed the boom in raw materials prices, increasing demand for Treasuries on the part of central banks as well as financial institutions in commodity-producing countries.2. It pushed up the value of emerging market currencies, prompting emerging market central banks to intervene in foreign exchange markets by purchasing dollars which then were invested in Treasuries.3. It contributed to the rise in global equity prices, which prompted investors to diversify their portfolios and purchase safer assets including Treasuries.

The carry trade, in which investors borrow low-interest currencies (dollars or yen) and buy high-interest emerging market currencies, created demand for Treasuries by funneling money into emerging markets that ended up as dollar reserves in their central banks.

At the peak of demand for US government securities, net foreign purchases of Treasuries came to $400 billion per year, according to the Treasury’s TIC data base (Exhibit 5). Who were the buyers? The Treasury data offers some answers.

Exhibit 6: Foreign holdings of US Treasury securities as of August 2008 (US$ billions): total holdings, year-on-year %change, and year-on-year absolute change.

We observe that the biggest increase came from offshore banking centers (the UK, Switzerland, Luxembourg, and Caribbean banking centers). This tells us little because anyone may transact through such centers. “Other emerging markets”, notably Brazil and other commodity producers, were the second-largest contributor, followed by Japan and the oil exporters.

Private purchases of Treasuries are larger than official flows in recent years, as shown in Exhibit 7:

As noted, private purchases of US Treasuries seem to scale to global wealth. We observe a fairly close relationship between global equity market capitalization (as measured by the MSCI World Index) and private purchases of US Treasuries, as in Exhibit 8.

An exception occurred during the peak of the US equity boom of the late 1990s, when Treasury purchases fell off at the peak of the boom. Evidently this exception reflected the general euphoria of the time and investor preference for riskier assets. We do not have Treasury data past August, and it well may be the case that a similar exception will emerge during the second half of 2008, as foreign investors increase their net purchases of Treasuries while stock markets crash, and for a symmetrically opposite reason. Investors may prefer safer assets.

We cannot directly estimate the impact of de-leveraging on the Treasury market, but it seems clear that the explosion of leverage during the past five years had a profound, if temporary, impact on the world market’s demand for US government securities. As a rough gauge of the growth of global leverage, we observe that between 2003 and 2008, US banks’ claims on foreigners nearly tripled from $1.2 trillion to $3 trillion.

Exhibit 9: American banks’ claims on foreigners.

We can observe in the movement of market prices, though, a close relationship between the breakdown of the carry trade and the rise in real Treasury yields. Withdrawal of leverage from the system forced market participants to liquidate carry trade positions, that is, to unwind short positions in Japanese yen, and to liquidate long positions in carry trade currencies such as the Brazilian real, Turkish lira, South African rand, Australian dollar and so forth. I use the parity of the Brazilian real to Japanese yen as a rough proxy of demand for carry trade. As Exhibit 10 below makes clear, the collapse of the carry trade (the fall of the Brazilian real against the yen) closely tracks the rise in 10-year TIPS yields. The visual relationship is confirmed by econometric analysis.

The Treasury market benefited from the explosion of bank leverage during the past 10 years, as emerging market central banks became the most important new buyers of US government securities. De-leveraging and the collapse of commodity markets combine to destroy global demand for Treasuries, limiting the US government’s capacity to borrow from overseas sources.

Other major holders of US Treasury securities are likely to wish to reduce their holdings rather than to increase them. China’s accumulation of foreign reserves represented “rainy day” savings for the nation, and the severity of the present crisis shows how well-advised China was to accumulate a large volume of reserves. China has announced plans to spend the equivalent of 20% of gross domestic product in a stimulus program which is likely to increase the country’s demand for foreign capital goods.

China’s trade surplus is likely to diminish sharply, both due to falling export demand and import growth arising from the stimulus package. Chinese reserves are likely to cease growing and may even decline as a result. Oil-producing countries, moreover, may have to spend reserves in order to maintain import levels as a result of the collapse of oil prices.

Foreign net purchases of US Treasury securities peaked at a $400 billion annual rate, and will fall sharply from this level. Domestic resources to purchase Treasury securities, moreover, are thin. When Ronald Reagan took office, America’s personal savings rate was 10%; today it is around 0%, although it has spiked up in recent months. Disposable income in the US now stands at slightly under $11 trillion. If the US returned to the personal saving rate of 1981, individuals would save $1 trillion a year, enough to fund the Treasury deficit, assuming that all net new portfolio investment flowed into Treasury securities. Nothing, though, would be left over for investment in anything else.

One way to gauge how onerous the Treasury’s borrowing requirements appear compared with available savings is to take the ratio of government borrowing to gross private savings, as in Exhibit 11 below.

Exhibit 11: Federal budget deficit as a % of gross private savings.

We observe that in 1981, the deficit stood at around 15% of gross private savings, and reached 30% at the worst. The deficit already has reached 50% of gross private savings, before the new administration has had the opportunity to increase spending.

In 1981, moreover, the United States was in current account surplus, and foreign purchases of Treasury securities were a very small factor in the financing of the government deficit. Today, the current account deficit (and the corresponding capital account surplus) is almost 6% of GDP.

It is far from clear from whom, and on what terms, the US Treasury will obtain $1 trillion a year, or even more, to finance its deficit. The overseas well has run dry, and domestic financing of the deficit would require a drastic increase in the savings rate at the expense of spending, or outright monetization of the debt by the Federal Reserve.

One way to increase the government savings rate, of course, is to increase taxes, but that is an unlikely course of action during a severe recession.

Monetization of debt remains a possibility, and to some extent would only continue the current trend. Total Federal Reserve Bank credit outstanding has more than doubled in the year to November 6, 2008, rising by $1.2 trillion to $2.06 trillion. This reflects loans, securities purchases, and related actions by the Fed to bail out the financial system. If the deflation persists, the Federal Reserve may be compelled to purchase US government debt.

Another possibility is that risk appetite among investors at home and abroad will continue to fall, inducing a portfolio shift towards Treasury securities. In this case “crowding out” will occur through risk-preference. It will not be so much that competing borrowers are crowded out of the lending market, but that investors will stampede away from risk. In this scenario, even a very low federal funds rate will not help to restore economic activity.

The point of lowering the risk-free rate is to push investors towards riskier assets. In a normal business cycle, falling output leads to lower yields on low-risk bonds, which in turn encourages investors to add risk to their portfolios by investing in businesses. If the safest of all investments, namely US Treasuries, suddenly offer much higher real yields, comparable to the boom years of the late 1990s, why should investors take risk?

In any of these scenarios, the result of global de-leveraging is dire: the more the US government tries to bail out businesses and households, the more bailing out the economy will need. The Bush administration’s response to the financial crisis, and the likely content of the Obama administration’s economic program, will deepen and prolong the economic downturn.

It is not generally remembered that the premise of the Reagan administration’s tax cuts was Robert Mundell’s work on the optimal level of government debt. Mundell, who won the Nobel Prize in 1991 for his work on international economics, observed that an increase in government debt might represent an improvement in market efficiency, if it corresponded to an increase in incomes. That might occur if a reduction in taxes caused an increase in the deficit, while stimulating economic growth. In that case, Mundell argued, a tax cut would increase efficiency if the additional revenues arising from the growth effect were larger than the interest on the bonds issued to cover the ensuing deficit.

In 1981, Ronald Reagan had a very different starting point:1. The personal savings rate stood at 10%.2. The current account was in surplus.3. The top marginal tax rate was 70%.

The capacity of the US and the world to finance an increase in the federal deficit was much greater, and the incentives arising from reducing the top marginal tax rate from 70% to 40% were much greater than any incentives that might be envisioned from tax cuts from the present level.

Even the best-designed economic policy would be hard-put to provide growth incentives without a substantial increase in the savings rate and a corresponding reduction of consumption, implying a very sharp economic contraction. If the Treasury tries to spend its way out of recession, the results are likely to be very disappointing.

David P Goldman was global head of fixed-income research for Banc of America Securities and global head of credit strategy at Credit Suisse.